New research confirms and outlines the implications of the relationship between capital flows and risk-adjusted performance of funds of hedge funds.

The BNP Paribas Hedge Fund Centre team led by Bill Fung and Narayan Naik used a comprehensive dataset of Funds of Hedge Funds (FoHFs) to investigate performance, risk and capital formation in the hedge fund industry over the past ten years, and confirms the finding of high systematic risk exposures in FoHF returns in a working paper titled 'Hedge Funds: Performance, Risk and Capital Formation'.

The team divided up the past ten years into three distinct sub-periods and demonstrated that the average FoHF has only delivered alpha in the short second period from October 1998 to March 2000.

In the cross-section of FoHFs, however, the team identified FoHFs capable of delivering persistent alpha. The authors stated: 'We find that these more successful hedge funds experience far greater (and steadier) capital inflows than their less fortunate counterparts.'

The team used data from the hedge fund industry to test the implications of the Berk and Green (2004) rational model of active portfolio management.

Berk and Green's 2004 rational model of active portfolio management implies that diminishing returns to scale combined with the inflow of new capital leads to the erosion of superior performance over time. In keeping with this implication, the paper provides evidence that even successful hedge funds have experienced a recent, dramatic decline in risk-adjusted performance.

The authors concluded: 'Consistent with the model, we find that there are significant differences in the ability of managers to deliver alpha. Our evidence is also consistent with investors perceiving these ability differentials, and in response, directing a steady stream of capital to the managers with higher ability. This persistent inflow of capital is associated with a decline in the alpha produced in the hedge fund industry. The decline is experienced by all managers regardless of ability.'

'Our results also suggest that there is an apparent mismatch between the supply and demand for alpha.'

'On the one hand, the supply of alpha appears to be drying up. On the other, capital appears to be seeking alpha. This could presage changes in the organization of the hedge fund industry.'

'Contracts in the hedge fund industry are currently structured to reward managers for generating returns above pre-specified fixed benchmarks. The findings in this paper suggest that conditioning incentives on risk-adjusted performance may be preferable.'

A pdf copy of the paper 'Hedge Funds: Performance, Risk and Capital Formation' may be downloaded from the BNP Paribas Hedge Fund Centre website at: www.london.edu/hedgefunds.html[2]

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